When a debtor files for bankruptcy, often its creditors will seek to enforce their rights against assets that may constitute collateral while the debtor will seek to limit or altogether avoid the creditors’ interests in those very same assets. In In re Strata Title, LLC, the debtor learned the hard way that arguments that win the battle may not necessarily win the war. There, although the debtor was able to avoid a creditor’s lien on a valuable asset, it was not able to avoid the automatic postpetition transfer of the asset’s title to the creditor.
Strata Title, LLC, a single member LLC, owned a membership interest in Tempe Tower, LLC. Tempe Tower, in turn, was a sole purpose LLC that owned and operated real property located in Tempe, Arizona. At the time Tempe Tower was formed, and according to its operating agreement, Strata Title and Pure Country Tower, LLC each held a 50% membership interest in Tempe Tower. Schedule 1 to Tempe Tower’s operating agreement, however, provided that if Pure Country did not receive a return of its initial $850,000 capital contribution on or before February 23, 2013, then all the membership interests in Tempe Tower would transfer to Pure Country.
Before the February 23, 2013 deadline, Strata Title filed chapter 11 and sought to reject the Tempe Tower operating agreement as an executory contract. Pure Country objected. After a hearing, the Bankruptcy Court found that the operating agreement was indeed an executory contract and granted Strata Title’s motion to reject. Pure Country then sought an order from the Bankruptcy Court declaring that Strata Title’s initial 50% membership interest was not property of the estate, either as of the petition date or at the time Pure Country sought to challenge Strata Title’s interest. Alternatively, Pure Country sought either relief from the stay to compel Strata Title to transfer its membership interests to Pure Country or a determination that Pure Country held a security interest in Strata Title’s membership interests and was entitled to relief from the stay to foreclose on those interests.
The Bankruptcy Court identified five specific questions it needed to answer before it could resolve the parties’ dispute: (1) Were the membership interests in Tempe Tower property of the estate at filing? (2) What effect did rejection of the Tempe Tower operating agreement have on enforcing Schedule 1? (3) Did Pure Country hold a perfected security interest in the membership interests? (4) Did the Debtor still hold a property interest in the membership interests? and (5) Was relief from the automatic stay warranted to allow Pure Country to foreclose on the membership interests?
Addressing each question in turn, the Bankruptcy Court first held that the 50% membership interest held by Strata Title was property of the estate as of the petition date. Despite Pure Country’s contentions that Schedule 1 effected an absolute assignment – and despite the operating agreement stating that the assignment was “irrevocable” – the Bankruptcy Court held that because the assignment could be eliminated if Pure Country’s initial capital contribution was paid from any source by the deadline and there was no indication that Strata Title’s liability to Pure Country was reduced based on the assignment, there was no absolute assignment. Rather, the Bankruptcy Court agreed with Strata Title that the operating agreement merely pledged the membership interests as security for Strata Title’s obligation to repay Pure Country’s capital contribution.
Second, and unsurprisingly, the Bankruptcy Court held that rejection of Tempe Tower’s operating agreement did not terminate the agreement. Rejection merely acted as a prepetition breach of the operating agreement, and state law would continue to determine how the parties’ rights would be treated under the operating agreement.
Third, under Arizona state law, the Bankruptcy Court found that the assignment of Tempe Tower’s membership interests to Pure Country constituted an unperfected security interest. In most cases, LLC membership interests would be classified as general intangibles, requiring the filing of a UCC statement for a creditor to perfect a security interest in those assets. Pure Country had failed to file a UCC statement, leaving its security in the membership interests vulnerable to avoidance. Rather than concede on this point, however, Pure Country attempted to argue that the membership interests were instead a form of “investment property” under Arizona state law, requiring only control for perfection. To constitute “investment property,” the membership interests first had to qualify as “securities.” The definition of “securities” required the Tempe Tower membership interests be traded on a securities exchange, its express terms provide it was a security, or that it was actually an investment company security. The Tempe Tower membership interests were none of the above. Reasoning in reverse, the Bankruptcy Court held that the membership interests were not “securities” and therefore could not be “investment property.” Because the membership interests were not “investment property,” perfection could not occur by mere control. And because Pure Country failed to properly perfect its interest in the membership interests, its interest was avoidable.
Notwithstanding the Bankruptcy Court’s holding that Strata Title would be able to avoid Pure Country’s unperfected security interest, it also held that Strata Title would not be able to “avoid the consequences of Schedule 1 as a contractual term” if the provision was enforceable under Arizona state law. Ultimately, the Bankruptcy Court found that Arizona law expressly authorized operating agreements to contain provisions regarding changes in classes of members and the acquisition of members’ interests. Further, because the relevant provision in Schedule 1 was self-enabling, the automatic stay did not prevent the shift of membership rights from Strata Title to Pure Country. And to the extent Pure Country was required to affirmatively act, the Bankruptcy Court found cause existed to lift the automatic stay to allow Pure Country to effectuate the terms of the membership interest transfer. So, notwithstanding the debtor’s victory in avoiding any lien on the membership interests in the LLC, it still lost the war when the court found that the membership interests transferred as a matter of contract law.